The ideal price for any product or service is one that is acceptable to both buyer and seller. From the buyer's standpoint, the right price is a function of product purchase value and other competitive choices in the marketplace. From the your vantage point, the basic concern for almost all small businesses is to price products to maximize both sales and profits, while providing enough margin to take care of applicable marketing and overhead expenses.

We recommend the following steps for determining product pricing for your business:

Analyze the size and composition of your target market.

Research price elasticity for your product.

Evaluate your product's uniqueness.

Select your channels of distribution.

Consider product life cycles.

Analyze your costs and overhead.

Estimate sales at different prices.

Consider secondary pricing strategies.

Select final pricing levels.

Market Size and Composition Affects Pricing Decisions

One of the first calculations you must make to set prices for your product or service is estimating approximately how large your potential sales volume could be, based on a reasonable assessment of your potential market share in the product category, at different price levels. Knowing the size of the existing market is critical to determining if there are enough customers to establish and grow a business.

In an established market, in order to sell your product you must cut into your competitors' market shares. Who will you compete against? What are their strengths and weaknesses? Are any direct competitors vulnerable to your products? Are any competitive products priced too high or not providing product "value" for the price? Secondary market research can help you answer all these questions.

Price Elasticity Factors into Pricing

If demand for your product or service changes significantly with slight changes in price, the product category is considered to be elastic with respect to price. If no significant volume changes occur, even with significant price changes, the category is inelastic.

Example

Grocery store items are often very price sensitive, with +/- 10 percent price changes resulting in significant share and volume changes per brand. In contrast, high-end gourmet food categories are often inelastic. It may require a price increase or decrease of 50 percent to create any perceptible changes in consumers' behavior. Consumers shopping these premium-priced categories are not as value-conscious as shoppers in a regular grocery store environment.

What Does Price Elasticity Mean for Product Pricing?

The greater the price elasticity, the closer you should price your products to similar competitive products and vice-versa. While your product may be unique, consumers will not pay much of a premium for it if there are similar competitive choices at lower prices.

To find out more about price elasticity in your industry, study secondary data sources (e.g., Nielsen, SymphonyIRI Group) for share and volume results correlated with brand pricing reductions. Talk to trade and association experts to obtain a feel for pricing elasticity.

Only Unique Offerings Can Support Premium Pricing

The closer your product resembles competitive products, the smaller the price differences that buyers will tolerate. And the less the product differences between brands, the greater the probability is that the category is price-elastic, and that brand-switching will occur when products go on sale.

It is not enough for a product to be unique. The sources of product uniqueness must be both recognizable and valued by buyers. And depending upon the category, very unique products may or may not be readily accepted by buyers. For example, gourmet food products have many distinct and unique attributes in any given category. Buyers shop for gourmet products because they are often looking for new, unique products—"something out of the ordinary."

However, the majority of products sold through mass merchandise stores, grocery stores, chain stores, and vending outlets are easily substituted from among many similar brands. Sources of brand uniqueness are generally very small differences. Usually, buyers aren't looking for new or unique items in these categories.

What does product uniqueness mean for pricing? Product uniqueness does not guarantee a significant price premium over a competitive product, if the product differences aren't recognizable and meaningful to consumers. And depending upon the category, even recognizable and meaningful product differences may not be enough to get buyers to switch to the new product, even at parity pricing, let alone at a premium price over the competition.

Field testing on a small market basis is highly recommended for questionable new product differences and unique new products.

Product Life Cycles and Product Costs Affect Pricing

Many product categories have significant evolution and life cycles
that may affect pricing decisions. For example, with personal computers
and software, the trend is toward shorter and shorter product life
cycles. In fact, it now takes as little as six to 12 months before new
technology and products are introduced in these multi-billion dollar
categories. As a result, product pricing cycles have also accelerated to
match, with introductory pricing decreasing to significantly lower
levels only six to eight months later. These continuously evolving
high-tech categories make it difficult for companies to recover
development costs, accurately predict sales volume, afford planned
marketing support, and price products accurately in relation to a
competitor's products.

Pricing Must Do More than Recoup Costs and Overhead

The most common errors in pricing are:

pricing products or services based only on the cost to produce them

pricing products based only on competitors' prices

Several objectives need to be addressed in determining correct product pricing:

Cover the cost of producing the goods or services.

Cover marketing and overhead expenses.

Provide profit objectives.

Afford distribution margin discounts.

Afford sales commissions.

Be competitive.

Breakeven Analysis

Breakeven analysis is a commonly used method that focuses on the
volume of sales at which total revenues will equal total costs. The idea
is to set the price of a unit of product or service at a level where it
will cover all of its own variable costs (material, labor, marketing
etc.) plus its portion of the fixed costs of the company (overhead). At
the point where enough units have been sold to cover all fixed and
variable costs, breakeven is achieved. After that point, the sales price
of a unit sold minus the variable (direct) cost to produce it equals
pure profit.

Example

A case of bottled tea beverages in 12-ounce
ready-to-drink bottles has a cost of goods of $3.82 per case of 12.
Factory price to distributors is $6.54/case. Gross margin (price minus
cost of goods) is $2.72/case. If the company's fixed costs (e.g.,
overhead, factory expenses, etc.) are estimated at $75,000.00 per year,
then the breakeven point would be 27,573.5 cases of tea ($75,000 divided
by $2.72/case).

"Keystone Pricing" Is Common in Many Industries

Many other industries, such as restaurants, other retail
establishments, and consulting services, operate on the "keystone"
pricing principle:

The cost of goods is limited to 33 percent, or one-third of retail prices.

Labor and overhead is limited to another 33 percent of retail prices.

Gross profits are a minimum of 33 percent of retail prices.
(Remember to keep the emphasis on gross. Remember that taxes, interest, and overhead expenses
must be deducted before net profits are determined.)

Markups Are the Cornerstone of Wholesaling and Retailing Pricing

Retailers and wholesalers need to consider the issue of markups in
their pricing structure, and manufacturers or other product producers
need to be aware of the average markup in their industry. A "markup" is
the percentage of the selling price (or sometimes the cost) of a product
which is added to the cost in order to arrive at a selling price. In
contrast, a "markdown" is a percentage reduction from the selling price.

Be aware that there are two different ways to calculate markup—on
cost or on selling price. So when you ask someone "what's your markup on
that item?" the answer you want is not just "20 percent," for example,
but "20 percent of cost" or "20 percent of selling price." In retailing, the industry standard is to compute markup as a percentage of selling price.

Example

Joel received a shipment of clocks that he
will sell in his gift store. He paid $12.00 for each clock and plans to
make $4.00 on each one. The selling price is then $16.00.

As a product wends its way through a distribution channel, each step
along the journey adds a markup before selling the product to the next
step.

Here's an example of how markups work based on selling price:

Level

Category

$

%

Producer

Cost

20.00

80.0

Markup

5.00

20.0

Selling Price

25.00

100.0

Wholesale Outlet

Cost

25.00

71.5

Markup

10.00

28.5

Selling Price

35.00

100.0

Retailer

Cost

35.00

70.0

Markup

15.00

30.0

Selling Price

50.00

100.0

Markups vary widely among industries. For example, average markups
(on selling price in these cases) are 14 percent on tobacco products, 50
percent on greeting cards, 8 percent on baby food and often more than
50 percent on high-end meats.

Markups, like all pricing strategies, depend on three influences — cost, competition, and demand.

Estimating Sales at Different Prices

The probability of significant sales volume differences at different
prices depends upon the price elasticity of the market and number of
similar competitors.

The first step in this analysis is to determine how many similar
direct competitors you have and their pricing differences. Perceived
value is also important in many categories: strict price per unit or
ounce comparisons may not be meaningful to buyers, if they perceive that
one product is of much higher quality than another.

Next, determine price elasticity, or "price sensitivity" for the
market. If you have a price-sensitive category and large volume
differences occur at various price differences with products on sale, it
still may be difficult to accurately measure price versus volume
differentials since other factors may also come into play.

The length of time various brands have been on the market, their
relative market share, brand loyalty factors, advertising and promotion
spending levels, sales support, merchandising efforts, distribution
penetration levels/market all have an influence on the pricing versus
volume equation.

In addition, internal company objectives need to be addressed, including:

cost of goods

marketing spending

overhead

sales commissions

distributor markups

shipping costs to distributors

profit objectives

Pricing at different levels to generate different volume levels may
not address benchmark company objectives. Pricing must cover all costs,
spending, and margin objectives.

Evaluate A Variety of Pricing Strategies

In addition to the primary goal of making money, a company can have
many different pricing objectives and strategies. Larger companies may
utilize product pricing in a predatory or defensive fashion, to attack
or defend against a competitor.

Example

Maxwell House Coffee introduced a second,
low-priced brand into their own dominant eastern United States markets
during the 1970s in order to slow and confuse the introduction of
Folger's Coffee into their markets. This new product was packaged and
designed to resemble Folgers familiar red can, with pricing set below
Folgers Coffee. The new temporary product clogged grocer shelves and
made it more difficult and expensive for Folgers to introduce their
coffee into new eastern markets.

If you have a premium-quality product, with premium packaging,
graphics, and unique features and benefits, perhaps a premium price is
necessary to reinforce the premium brand image. Higher margins than
normal may be one benefit. High prices confirm perceptions of high value
in consumer minds.

A good pricing strategy will also indicate guidelines for action in
the case of price increases or decreases. For example, "We will price at
or near the share leader's pricing on a per unit basis. We will
increase prices to follow a share leader price increase, but only to
preserve margin objectives."

Strategically, you may want to consider temporarily delaying
necessary price increases driven by supplier and ingredient price
increases. Take affordable, smaller profit margins if your category
segment is price elastic. If competitors are increasing prices
and your company decides not to, this could be a temporary advantage for
your company since sales volume may increase.

Be sure to consider variations that may come
up to affect your pricing. You may wish to use discounting for prompt
cash payment or for quantity purchases. Seasonal items may warrant
special pricing from time to time. How about senior citizen and student
discounts? And promotional incentives may motivate your dealers. These
are but a few of many variables you'll want to consider when you
formulate your pricing strategy.

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